What is a Finance Lease?
A finance lease is a type of lease arrangement where the lessor transfers substantially all the risks and rewards of ownership of an asset to the lessee. In accounting terms, it is treated as if the lessee owns the asset, which means that the lessee recognizes the asset on their balance sheet and accounts for depreciation and interest expenses.
Examples
Example 1: Leasing Industrial Equipment
A manufacturing company leases a piece of industrial equipment with a lease term that closely matches the equipment’s useful life. The company assumes the responsibility for maintenance, insurance, and other risks associated with the equipment.
Example 2: Office Building Lease
A company enters into a lease agreement for an office building where the lease term covers the majority of the building’s economic life. The lessee is responsible for all costs associated with the building, including substantial upgrades.
Frequently Asked Questions
What distinguishes a finance lease from an operating lease?
A finance lease transfers the risks and rewards of ownership to the lessee, whereas an operating lease does not. In an operating lease, the asset remains on the lessor’s balance sheet. The lessee only incurs lease costs as expenses.
How is a finance lease recognized on financial statements?
A finance lease is recorded on the balance sheet as both an asset and a liability at the present value of minimum lease payments. The lessee then depreciates the asset and amortizes the liability over the lease term.
What criteria are used to classify a lease as a finance lease?
According to the Financial Reporting Standard (FRS) 102 and International Accounting Standard (IAS) 17, a lease is classified as a finance lease if it meets any of the following:
- The lease transfers ownership of the asset to the lessee by the end of the lease.
- The lessee has the option to purchase the asset at a price expected to be lower than its fair market value.
- The lease term is for the majority of the asset’s useful economic life.
- The present value of lease payments equals or exceeds the fair value of the asset.
- The asset is specialized and can only be used by the lessee without significant modifications.
Operating Lease
An operating lease is a lease arrangement where the lessor retains ownership and the lessee simply uses the asset for a specific period. The asset is not recorded on the lessee’s balance sheet.
Capital Lease
Another term often used interchangeably with a finance lease, highlighting its nature of capitalizing both the asset and associated liability on the balance sheet.
Lease Liability
A financial obligation recorded on the balance sheet representing the payments the lessee has committed to make under the lease agreement.
Depreciation
An accounting method of allocating the cost of a tangible asset over its useful life. In the context of a finance lease, the leased asset is depreciated in the same way as owned assets.
Present Value
The current value of future lease payments, discounted at the lessee’s incremental borrowing rate, which is used to determine the liability and asset values on the balance sheet in a finance lease.
Online References
Suggested Books for Further Studies
- Financial Accounting: An Introduction by Pauline Weetman
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Accounting Principles by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
- Advanced Accounting by Joe Ben Hoyle, Thomas Schaefer, and Timothy Doupnik
- Principles of Accounting by Rick Wild and Frank Wood
Accounting Basics: “Finance Lease” Fundamentals Quiz
### Does a finance lease transfer ownership of the asset to the lessee?
- [ ] No, ownership always remains with the lessor.
- [ ] Yes, immediately upon lease agreement.
- [x] Yes, often by the end of the lease term.
- [ ] No, it never involves transfer of ownership.
> **Explanation:** A finance lease often includes conditions that will transfer ownership of the asset to the lessee by the end of the lease term or offer an option to purchase the asset at a nominal price.
### Which of the following criteria can classify a lease as a finance lease?
- [x] Present value of lease payments equals or exceeds the fair value of the asset.
- [ ] Lease payments are made monthly.
- [ ] The asset is insured by the lessor.
- [ ] The asset is used for a period shorter than its useful life.
> **Explanation:** One of the key indicators of a finance lease is when the present value of minimum lease payments equals or exceeds the fair value of the leased asset.
### How should a lessee record a finance lease on their balance sheet?
- [ ] As a contingent liability.
- [ ] Exclusively as an expense.
- [ ] Only as a form of equity.
- [x] As both an asset and a liability.
> **Explanation:** A lessee records a finance lease as an asset and a corresponding liability at the present value of minimum lease payments on their balance sheet.
### What is another primary term for a finance lease used in accounting?
- [x] Capital Lease
- [ ] Operating Lease
- [ ] Equity Lease
- [ ] Transaction Lease
> **Explanation:** The term "Capital Lease" is commonly used synonymously with finance lease, especially in old GAAP terminology.
### When recognizing a finance lease, which type of expense is recorded on the income statement?
- [ ] Only lease expense.
- [ ] Only interest expense.
- [x] Both depreciation and interest expense.
- [ ] Only maintenance expense.
> **Explanation:** Finance lease recognition includes recording interest expense on the liability and depreciation expense on the leased asset on the income statement.
### What standard provides guidance on finance leases for UK listed companies?
- [ ] GAAP 99
- [ ] FRS 105
- [x] IAS 17
- [ ] US-centric FASB guidelines
> **Explanation:** IAS 17, part of the International Financial Reporting Standards (IFRS), provides the guidelines for recognizing and measuring finance leases.
### Which of the following is a benefit for lessees in a finance lease arrangement?
- [x] Ownership-like control without initial full pay-out.
- [ ] Complete avoidance of maintenance responsibilities.
- [ ] The ability to hide liabilities from balance sheets.
- [ ] Immediate profit generation from the asset.
> **Explanation:** One clear benefit for lessees is exerting ownership-like control over the asset while spreading payments over the lease term, modulated by recording assets and liabilities on the balance sheet.
### Under IAS 17, which statement is correct about the present value of lease payments?
- [ ] It should always be at retail price.
- [ ] It is always higher than the asset's cost.
- [x] It equals or exceeds the fair value of the asset.
- [ ] It is discretionary to reflect actual market value.
> **Explanation:** Under IAS 17, one indicator of a finance lease is when the present value of lease payments equals or exceeds the fair value of the leased asset.
### For a lease to be classified as a finance lease, how much of the asset’s useful life does the lease term usually cover?
- [ ] Less than 25%.
- [ ] Less than 50%.
- [x] The majority (more than 50%).
- [ ] Less than 10%.
> **Explanation:** The lease term covering the majority of the asset's useful economic life is one of the conditions classifying it as a finance lease.
### According to financial standards, which responsibility does a lessee generally not undertake in a finance lease?
- [ ] Depreciation
- [x] Sale and resale rights to multiple parties
- [ ] Insurance of the asset
- [ ] Maintenance
> **Explanation:** While a finance lease typically entails the responsibilities akin to ownership (such as depreciation, insurance, and maintenance), it does not usually grant the lessee rights to sale and resale of the leased asset multiple times without additional agreements.
Thank you for exploring finance leases through this comprehensive guide and testing your understanding with our quiz. Keep enhancing your financial knowledge!
